JANE FOLEY<br /><strong>RESEARCH DIRECTOR, FOREX.COM</strong><br /><br />AFTER months of heavy handed fiscal and monetary stimulus, the fact that central bankers and finance ministers are turning their attention to exit policies offers some reassurance that conditions must be returning to normal. This is not, however, a time for complacency. <br /><br />Over the past couple of months, investors’ fears have been calmed by the perception that green shoots are appearing but the global economy has a long way to go before recovery is established. The world economy may be a far more stable place than it was nine months ago, but its continued weakness means it is still vulnerable to negative shocks so there is still good reason to expect choppy conditions over the summer months.<br /><br />Over the past month the Volatility Index (VIX) has been trading lower, at levels not seen since before the collapse of Lehman. This is good news, though it should be noted that before last year, the last time the VIX held present levels was early 2003. On a relative basis, volatility is still high. <br /><br />At the same time as the decline in the VIX and the move higher in government bond yields, the US dollar has also given back much of the safe haven gains from the height of the financial crisis. Between March and early June there was a period of US dollar depreciation versus the euro. Risky currencies such as the Australian dollar saw a 30 per cent rise against the US dollar over the same period.<br /><br /><strong>STABLE CONDITIONS</strong><br />The aggressive policy measures adopted by central banks have no doubt contributed to the more stable financial market conditions we have seen of late. But despite the efforts to restore the availability of credit, British Bankers’ Association (BBA) data for April show that overall lending to UK non-financial companies declined, while High Street bank’s net mortgage lending was the lowest for eight years. The minutes of the June MPC meeting highlight that constraints in the supply of credit is a concern for the Bank of England and a lack of availability of credit is being reported elsewhere in Europe too. <br /><br />Put together, both higher long-term interest rates and difficulties in obtaining credit feed the risk that the economic recovery will be drawn out. The likelihood that the recovery will not be V-shaped will create a second tier of problems insofar as the incidence of bad debts will rise. <br /><br />As a consequence, attention is increasingly turning to the European banks. The ECB has estimated that Eurozone banks will announce $283bn of losses by 2010, a figure which many critics see as conservative and a prolonged recession will no doubt push this figure higher. While the US and UK banking sectors are not through the woods yet, the less transparent Eurozone banking sector means that it is more likely to produce negative shocks over the summer. Another wave of bad news would undermine business and consumer confidence and risk extending the recession even further. <br /><br />The gains made by risky currencies over the past few months reflect the relative economic and financial sector stabilisation achieved to date. The question now is whether the price movements in recent months fairly reflects risk or whether there has been over-emphasis on the green shoots story. <br /><br /><strong>UNANTICIPATED NEWS</strong><br />Over the summer months short euro-dollar positions could prove to be a good bet. The euro is likely to be on the back foot in anticipation of bad news from the Eurozone banking sector while the US dollar is likely to benefit not only from the likelihood that economic recovery will appear in the US ahead of the Eurozone, but also from any move back into safe haven assets resulting from unanticipated bad news. <br /><br />Medium-term, euro-dollar could head back towards the 1.3500 area. Shorting the euro against the pound has proved to be a profitable trade since mid-March. Even so, euro-sterling is still 26 per cent above its pre-Northern Rock crisis levels suggesting that sterling’s price is still reflecting a heavy amount of risk. <br /><br />Insofar as economic data is increasingly suggesting that the UK recovery will be underway ahead of that in the Eurozone, euro-sterling could continue to make downside progress towards the 0.800 area in the medium-term. <br /><br />As such, any upwards reversals in euro-sterling may prove to be decent sterling buying opportunities.<br /><br />Please send questions or comments to ResearchEmea@forex.com.